What Does Capitalization Rate Mean?
A capitalization rate (or "cap rate"), in the context of a business valuation, is a rate of return (expressed as a percentage) derived by deducting a growth factor from the weighted average cost of capital (WACC) for a subject company. The cap rate is a blended rate of return on the blended capital of a business including its debt and equity components.
The cap rate is used to convert a point estimate of cash flow into value. The inverse of a capitalization rate is referred to as the multiple.
Divestopedia Explains Capitalization Rate
Capitalization rates take into consideration three variables:
- the returns on equity, which is a function of the business' operating risk, excluding consideration of its financial risk;
- the appropriate long-term capital structure of debt vs. equity; and
- the marginal income tax rate at which interest expense is deducted.
Capitalization rates are applied to maintain discretionary cash flows before interest expenses. The capitalization rate is used most often to determine the terminal value in a discounted cash flow valuation analysis.
A higher capitalization rate represents a higher risk and, consequently, a lower multiple and valuation. A simple example of a capitalization rate of 20% equates to a multiple of 5.0x vs. a cap rate of 25% or a multiplier of 4.0x.